Liquidity Adjustment Facility (LAF)

The Reserve Bank of India as the lender of last resort provided various general and sector-specific refinance facilities to the commercial banks such as Export Credit refinance, collateralised lending facility. However in keeping with the recent policy objective of shifting from direct/ regulated/administered instruments to indirect techniques of market-based instruments of monetary control, it became necessary to get rid of all sector-specific and discretionary refinance facilities and to move towards a general policy of refinance facility. The Narsimhan Committee on banking sector reforms in 1998 suggested that for orderly movement of interest rates in interbank call money markets the RBI support to the market should be through the Liquidity Adjustment facility (LAF). Under this, the RBI would periodically, if necessarily daily, resets its repo and reverse repo rate which would in a sense provide a reasonable corridor for market play.

Accordingly the Interim Liquidity Adjustment Facility or ILAF was introduced from 21 April 1999 which was followed by the introduction of final LAF from Jun 5 2000.

Main provisions of Liquidity Adjustment Facility

1. The general refinance facility was withdrawn and replaced by a collateralised lending facility available at the bank rate.
2. Also an Additional Collateralised Lending Facility (ACLF) was made available at the bank rate plus 2% for a certain time period.
3. The absorption of liquidity from the market would be done through fixed rate repo.

In other words under ILAF funds are absorbed by the RBI from the financial system by the Repos at fixed interest rate but injected to the system at multiple rates though the standing refinance facilities and Additional Collateralised Lending Facility.

After the working of Interim LAF for about a year, a full-fledged Liquidity Adjustment Facility came into being in June 2000. The LAF operates through repo auctions, i.e. the sale of government securities from the Reserve Bank of India for absorption of liquidity and reverse repo auctions i.e., buying of government securities for injection of liquidity on a daily basis, thereby creating a corridor for the call money rates and other short term rates.

The funds under LAF are expected to be used by the banks for their day-to-day liquidity mismatches. The maturity of repos is from 1 to 14 days. All scheduled banks and primary dealers are eligible to participate in the repo and reverse repo auctions. The minimum bid size for LAF is 8.5 crores and in multiples of 5 crores thereafter. All transferable government dated securities or treasury Bills (except 14 days TBs) can be traded in repo and reverse repo market.

Under LAF the RBI periodically sets/ resets its repo and reverse repo rates, it uses three days or four days repos to siphon off liquidity from the markets. The repos are used for absorbing liquidity at the given rate (floor) and for infusing liquidity, reverse repos at a given ceiling or cap rate is used.

There thus exists an interest rate corridor in the interbank call money market with repo rate as the floor rate and the bank rate acting as the ceiling rate and the call rate acting as the middle rate.

Merits of Liquidity Adjustment Facility

1. Liquidity Adjustment Facility is the new short-term liquidity management techniques for managing the price and volume of liquidity in the economy.
2. It is a flexible instrument in the hands of the RBI to even out or to adjust or to manage the short term market liquidity fluctuations on a daily basis and to help create stable or orderly conditions in the overnight or call money market. It is meant to help monetary authorities to transmit the short term interest rate signals to other money markets and financial markets and to the long ends of the yield curve,
3. The repo operations also provide liquidity and depth to the underlying treasure securities market.
4. The LAF helps the banking systems also by providing it with an outlet for short term liquidity and thereby to optimise the return on short term surplus funds.
5. The Liquidity Adjustment Facility operations combined with the Open Market Operations and bank rate changes have become a major technique of monetary policy in India.
6. As the evolution of LAF has progressed the sector specific standing liquidity support to banks and primary dealers has been rationalised with export credit refinance being the only facility available since 5^th October 2002.
7. Further, the standing liquidity facility has been made progressively market-based with the entire export credit refinance made available at the reverse repo rate.
8. On 20^th October 2004 in order to switch to international convention, the repo came to be designated as the act of injecting liquidity while reverse repo became the act of absorbing liquidity under the LAF.

Read More about Repo and Reverse Repo Operations